California's slow and lackluster emergence from recession is prompting a wave of concern that the Golden State's glory days are gone for good – unless voters take action to address a dysfunctional governmental system.

Few disagree it's broken. California's finances are a perennial disaster; even after this summer's battle between Gov. Arnold Schwarzenegger (R) and the legislature to close a $26 billion budget gap, the Legislative Analyst's Office estimated this week that the state will run $20.7 billion in arrears over the next 18 months.

California was hit hard in the downturn, and the economic pain is expected to linger longer here. It leads the nation in foreclosures, with 459,906 homes lost to banks since the start of 2007, according to real estate research firm DataQuick. It lost the most jobs in the past year – 732,000 – and its unemployment rate has climbed to 12.2 percent, the fourth highest in the US. The University of California system is coping with a 20 percent funding cut this year.

The state now spends more on prisons than on higher education, say some politicians. Last year, it spent $10 billion to house the country's largest prison population in a system so overcrowded that federal judges are threatening to force the release of 40,000 inmates.

No wonder the doomsayers are having a field day. Britain's Guardian newspaper asks if California will become America's "first failed state." The New Republic ponders whether the California dream has turned into "a nightmare." Fortune magazine speculates that the state's unemployment rate could reach 15 percent.

But not everyone buys into the gloom and doom. "There's a greater loss of confidence than we have seen in the past, but the past has also shown Californians have a tremendous ability to bounce back," California pollster Mark DiCamillo says.

Still, the political and economic turmoil has provoked introspection. A majority of voters say "fundamental changes" are in order, according to Mr. DiCamillo's Field Poll. But while they say they want reform, voters are loath to undo the ballot initiatives that many experts say have led to today's mess.

California's initiative process puts power in the hands of the people as in no other state. Some 400 initiatives have been on state ballots since 1976. These have set term limits, banned gay marriage, taxed millionaires, and set aside 40 percent of the budget for education. The process has been hailed for giving people unequaled checks on politicians – and criticized for creating constitutional changes at the voters' whim.

Arguably the most controversial initiative is Proposition 13. The 1978 measure requires legislators to approve tax hikes by a two-thirds majority and capped property taxes at 1 percent of assessed value. Intended to keep taxes in check, the policy means the state must rely on its progressive income taxes for revenue, which then rises and falls with the economy.

Californians must rethink tax policies if they want to end the roller coaster of boom and bust, says Jerry Nickelsburg, a senior economist at the University of California, Los Angeles. "If [we] want to retain the [tax] system we have now, we are just going to have these cycles of deficits."

Recent polls show that Californians are reluctant to embrace tax reforms.

"The trouble is that no one can agree on a solution," says Henry Brady, professor of public policy and political science at the University of California, Berkeley. "[W]e are at a tipping point where California has to ask itself if it still wants to provide the institutions it has become known for."

Some Californians say only a constitutional convention can solve the crisis – a daunting prospect and one that critics fear would be hijacked by ideologues. California voters may be able to weigh in on the matter in 2010, with two planned ballot measures that call for a convention focused on changing the budget process – possibly diluting the requirement for budgets to pass with a two-thirds majority – and reining in initiatives.

Fixing the state may ultimately depend on whether the impetus for reform outlasts economic recovery. Most economists agree California will bounce back. While the state trails in emerging from recession, its long-term growth potential is strong. Export activity with Asia is increasing, housing prices are stabilizing, and job losses are slowing.

Some areas will rally faster: The technology-driven Bay Area will grow sooner than the Central Valley, where housing and agriculture have been hit hard. The state remains at the forefront of innovation: 40 percent of venture capital in the United States is still spent in California. Silicon Valley techies reign over the Internet, and Hollywood still produces blockbusters. The state will continue to draw immigrants in search of a dream.

"Right now, things are out of whack," says pollster DiCamillo, "[But] I would not be the one who would say, 'This will be it for the California dream.' I think it will rebound." •